While they don't expect an imminent banking crisis, nor an
increase in financial-market volatility as a result of weak
economic data alone, Ajay Rajadhyaksha and Jian Chang, members of
Barclays' cross-asset research team, believe that Chinese
policymakers will most likely face a tough decision when it comes
to the renminbi in the period ahead.

"In chess, the concept of zugzwang refers to a point in the game
where any change in the status quo weakens a player's position,"
the pair wrote in a research note released overnight.

"The ideal choice would be to not make a move, except that 'pass'
is not an option.

"This concept effectively explains the choices that confront
China's policy makers, who will have to make a decision about the
country's currency and monetary policy in the next few quarters.
None of the choices are terribly appealing, and all carry risks
for financial markets."

Rajadhyaksha and Chang's concerns, like those of others, revolve
around the sharp decline in Chinese foreign-exchange reserves
seen in recent months.

Unlike others, however, they do not believe that portfolio
revaluations or concerns surrounding the outlook for China's
economy are the main reasons for decline seen over the past six
months, pointing to easier monetary-policy settings from China's
central bank, the People's Bank of China, as the main catalyst
behind the accelerated decline.

"We believe that outflows are not being driven just by a loss of
confidence, but are a by-product of sharply easier monetary
policy, which resulted in M2 in the country rising by around
$2.5trn (in RMB equivalents) last year," the pair says. "While
this wave of RMB liquidity continues to wash over the Chinese
economy, capital outflows should continue."

Should this, rather than other factors, see FX reserves continue
to decline, Rajadhyaksha and Chang believe that policymakers will
have only three options to stem capital flows, and none of them
will be particularly palatable for markets.

They explain:

China could tolerate the current pace of FX reserve declines
for several more months. But at some point this year, the
People's Bank of China (PBOC) will probably have take more
aggressive measures to stem outflows. The choices are: a)
strict capital controls; b) a much tighter monetary policy; or
c) a sharp, one-off depreciation of the RMB. We do not think
capital controls will work, and monetary policy tightening
could slow down the economy, as well as spark credit defaults.
A one-off depreciation would have to be sharp enough that it
shifts psychology from future depreciation to appreciation,
thus reducing capital outflows. The RMB has appreciated 25-30%
trade-weighted over the past four years; all of that might need
to be unwound to decisively shift psychology. But this would be
a difficult "sell" in other countries, especially in a US
presidential election year.

Rajadhyaksha and Chang believe that the PBOC may try each of
these in small doses in the months ahead, testing the waters to
see which, if any, will be able to reduce mounting capital
outflows.

But they believe that if these steps fail to stem the tide, China
will have a tough decision to make, with the ramifications to be
felt worldwide.

"The choices the country makes over the next few quarters will
have ramifications for the global economy, as well as for world
financial markets," the two say. "And at least right now, there
do not seem to be any easy choices on the horizon."